The Pros and Cons of Health Savings Accounts

A Health Savings Account (HSA) provide tax savings and flexibility for individuals with high-deductible health plans, but they are not without their challenges.

Health Savings Accounts (HSAs) were introduced to replace medical savings accounts as part of the Prescription Drug, Improvement, and Medicare Modernization Act of 2003. At the end of 2017, there were more than 22 million HSA accounts which totaled an $45 billion. The HSA market is expected to rise to $64.3 billion by the end of 2019 – and for good reason. For most people, HSAs are a great way to pay for your medical expenses and also offer significant tax savings.

What is an HSA?

An HSA is a tax-advantaged savings account that helps individuals with high-deductible health plans pay their out-of-pocket medical expenses. Contributions to an HSA may be made by an individual and/or their employer, and may be used to cover medical treatments that are not covered by your health insurance plan such as dental, vision, over-the-counter drugs, and alternative medical care.

HSA advantages

Tax deferral. An individual may contribute up to $3,500 annually to an HSA and not be subject to federal income tax. People 55 or older can make “catchup contributions” and add an additional $1,000 to their HSA every year. Families may contribute up to $7,000 per year. HSA funds grow tax-free, and distributions for qualified medical expenses are not taxable.

Investment and growth. The vast majority of HSA owners maintain their accounts in cash only, which may be a big mistake. HSA monies can be invested in stocks, mutual funds, and other investments that could increase your return significantly over the long-term. Only funds that you expect to require in the short-term should be maintained in cash.

Portability. You can keep your existing HSA if you change jobs or enroll in a new health insurance plan, even if the new plan does not qualify.

Flexibility. Your HSA can also be used to reimburse for prior years’ medical expenses so long as the fund was established before the medical expenses were incurred. Although HSA funds can’t generally be used to pay health insurance premiums, they can be used for COBRA payments, to pay premiums during periods of unemployment, and for some types of Medicare premiums if you are 65 or older. They can also be used to pay premiums for long-term care insurance.

People tend to compare the HSA with the Flexible Savings Account (FSA), which is also used to pay for medical expenses. However, the HSA offers more flexibility than the FSA – for one thing, while unused FSA funds are forfeited at year-end, unused HSA funds roll over to future years. In addition, while the employee contribution amount for an FSA can only be changed at the beginning of the tax year, HSA contributions can be changed at any time.

Retirement and/or emergency funds. Beneficiaries of HSAs can use the funds for emergency medical conditions and to reimburse themselves for medical expenses paid from taxable accounts. After age 65, you can withdraw funds from your HSA without incurring a tax penalty, even if the funds are used for non-medical expenses.

Budgeting and savings challenges. It is difficult for most people to set aside funds for their HSA, particularly if they are elderly or sick. It is also hard to determine what amounts will be needed for any future illness – some people may be tempted to hold off on necessary treatment rather than dip into their HSA funds. Those who expect to have significant healthcare expenses may be better off spending their money on a higher-premium health insurance plan outside an HSA that has better coverage.

Penalties. Although funds may be withdrawn from an HSA for any reason, if the withdrawal is for an unqualified medical expense, the taxpayer will be subject to income tax and a 20% penalty. As with IRAs, if the taxpayer is 65 years or older there is no tax penalty but the withdrawal will still be subject to income tax. Note that the tax penalty may also be waived if the taxpayer is disabled at the time of withdrawal.

May not be deductible from state income tax. It is important to review tax treatment of HSAs in your state – for example, HSA contributions are not deductible for California state income tax purposes.

San Francisco tax planning

The accountants and tax attorneys at Moskowitz, LLP advise individuals and companies of all sizes on how to minimize their federal and state income tax liability. Contact our office today for a consultation.